Fed: High Unemployment Means Cheap Borrowing

(March 16) -- The Federal Reserve signaled it will keep the cost of borrowed money historically low for months to come because of persistently high unemployment and scant signs of inflation on the horizon.

The Fed left its target for benchmark interest rates for overnight loans between banks at zero to 0.25 percent. It also said the slack job market and a lid on both inflation and inflation expectations are "likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Since the makers of monetary policy hate surprising financial markets with their decisions, that continuing mention of "an extended period" is widely interpreted to mean the Fed won't start raising borrowing costs to pre-recession levels for at least a few months after it removes the phrase from its post-meeting statement.

But the Fed's language itself can be a powerful economic tool.

For the second month in a row, Thomas Hoenig, the president of the Kansas City Fed bank, voted against making such an implicit promise to investors. Hoenig "believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted, because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability," the Fed said.

In other words, Hoenig feared it would make executives and consumers expect that prices will rise, which will affect how much is charged for goods and labor and thus create actual inflation.

Minutes of the Federal Open Market Committee's last meeting in January showed that Hoenig worried the economy was improving enough that the Fed needed more flexibility when it came to interest rates and wanted to change "exceptionally low for an extended period" to "low for some time."

But his colleagues, including Fed Chairman Ben Bernanke, clearly think the economy is still on shaky ground even as it shows moderate improvement.

Though "economic activity has continued to strengthen," it said, "household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth and tight credit." Though business spending is rising for equipment and software, "employers remain reluctant to add to payrolls," the Fed noted, adding that "housing starts have been flat at a depressed level."

Despite the depressed housing market, the Fed also confirmed it will soon end its $1.25 trillion effort to buy mortgage-backed securities, a program enacted at the height of the financial crisis and aimed at lowering mortgage costs and unfreezing the loan market.